CHX and Four Types of Speed Bump

Speed bumps, the latest fad in market structure, are proliferating. The Chicago Stock Exchange (CHX) recently proposed a new type of speed bump in the US equities market, called the “Liquidity Taking Access Delay” (LTAD). [1] The SEC’s decision whether to approve the LTAD could have a big impact on market structure, possibly more so than the IEX decision.
To understand the consequences of approving LTAD, I think it’s helpful to consider four types of asymmetric access delay: [2][3]

An exchange applies a delay to orders that are accessing resting liquidity. Resting orders themselves may be modified or cancelled without delay. This is the LTAD.

The same as #1, except only resting orders that are non-displayed avoid the delay.

The delay applies to all client messages to the exchange, including cancellations and marketable orders. But the exchange operates algorithmic order-types which adjust their attributes without delay. In particular, a displayed order can be pegged to undelayed price data, while its potential counterparties are subject to the delay.

The same as #3, except only non-displayed algorithmic order-types avoid the delay. This is the IEX speed bump. [4]

Here’s a table of the speed bump combinations, split by which types of resting orders have functionality similar to last look:

Last look

Can apply to displayed quotes

Can apply to non-displayed quotes only

At discretion of resting order-sender

#1 (LTAD)

#2

At discretion of exchange algo

#3

#4 (IEX)

In my opinion, all four types do more harm than good to market end-users (in the context of Reg NMS) — each allows resting liquidity to fade in some way. But many end-users disagree, and asked the SEC to approve #4. So, now that speed bumps exist and non-displayed peg orders may elide them, which of the other three asymmetric delays should be allowed?
One school of thought is that exchanges have a duty to protect their peg orders to the maximum extent possible. Combining this principle with the new “de minimis” interpretation may imply that speed bumps of types #3 and #4 should be allowed. Healthy Markets takes this view. [5] I think it’s a bad idea for exchange algorithms to have a time-advantage that isn’t offered to traders. Exchanges have neither the incentive nor the expertise to optimize their pricing algorithms. [6] The traditional role of the exchange is to provide a meeting place for buyers and sellers, allowing them to transact at prices of their own choosing. Exchanges offer algorithmic order-types (like pegs) mainly for convenience, and I don’t think there should be any illusion that these order-types are as good as the techniques used by sophisticated brokers and traders. Providing exchange algos with a time-advantage will mean that they out-compete traders, who are otherwise superior in terms of their pricing accuracy, stability under stress, and diversity. Traders and their algorithms do make mistakes, but it’s hard to believe that an exchange algo monoculture can do better. Subsidizing inferior business methods reduces an industry’s productivity, and giving exchange algorithms a structural advantage would be no different.
In my view then, if #4 is allowed, then #2 should be allowed. And, if #3 is allowed, then #1 should be allowed. Since #4 is already approved, the only thing to consider is whether it should be permissible for delays to have asymmetries in how they apply to accessing displayed quotes. The comments mostly do a good job explaining why asymmetries are problematic for displayed market structure. [7] In short, if displayed orders are given extra time to decide whether to consummate a trade, a large number of quotes will be practically inaccessible, even though it’d be prohibited to lock, cross, or trade-through those quotes. [8] Even in markets without these regulations, such as FX, last look causes difficulty. [9] The consequences of combining last look with order protection are unpredictable, but they seem unlikely to be good for long-term traders.

So, if we don’t want Reg NMS order protection to apply to quotes eligible for last look, only options #2 and #4 should be permitted. There is a tradeoff, though. Giving only hidden orders a time-advantage will incentivize dark trading. I doubt that the major exchanges would become as dark as IEX, but the equities market would probably become less transparent.
IEX’s approval is already inspiring a dramatic increase in complexity. CHX might not be the most important exchange, but like IEX, any precedent it sets applies to other exchanges. [10] Restricting speed-bump-asymmetries to hidden orders has drawbacks, but it might be the only way Reg NMS can keep limping on.

[1] Technically, it’s not really new. The LTAD is similar to an old proposal from Nasdaq’s PSX, which was rejected by the SEC.

[2] In order to highlight the essential elements, I’m leaving out some details.

[3] There are other speed bump types of course. For example, an exchange could delay traders from cancelling resting orders, but allow incoming marketable orders to execute without delay. That sort of delay could be used to address complaints about “fading liquidity“, and is similar in some respects to Nasdaq’s tentative “Extended Life Order” and EBS’s “Minimum Quote Life“.

Delays in market data are speed bumps of an entirely different class. These are prohibited (I think) in US equities markets, which require quotes and trades to be published to the SIP without delay. Though perhaps this requirement doesn’t apply to “de minimis” delays?

[4] Algorithmic order-types may also use their undelayed data feeds to trade aggressively with resting orders which can’t be cancelled without going through a delay. IEX’s DPEG does this via its “book recheck” mechanism.

Time delays should not apply to an exchange’s ability to price orders on behalf of all participants (i.e. Pegging).

Dave Lauer clarified on Twitter that this principle also applies to displayed peg orders.

[6] CHX’s justification for the LTAD evokes a useful thought experiment. CHX argues that its ETF quotes are victims of “latency arbitrage,” and that the LTAD will prevent this. If the SEC rejects the LTAD, CHX might propose another type of speed bump, where CHX manages displayed orders in ETFs (e.g. SPY, QQQ, etc) by pegging them to undelayed CME market data. Will CHX understand the relationship that these ETFs have to futures markets as well as professional traders do? And these ETFs are just the simple cases — imagine what kind of pegs an exchange might come up with to prevent market makers from being “picked off” on XOM when the price of crude or CVX moves. I’m sure exchanges can think of peg algos that market makers would find very useful, but is that really what we want exchanges doing?

I found it interesting that Virtu publicly supported the LTAD as soon as it was announced, presumably before they had time to review the filings. Was the LTAD proposed at Virtu’s request? Could Virtu’s CHX profitability rely on market data revenue sharing?

[8] Without using ISOs, that is. If enough displayed orders were granted a last look, then the market would be clogged with inaccessible quotes. Only traders with the legal infrastructure to submit ISOs would be able to navigate the equity market.

[10] James Angel’s letter argues that CHX should be given the benefit of the doubt just like IEX was. I’m not a lawyer, and I think the LTAD could hurt long-term traders, but some of his points are persuasive.

4 thoughts on “CHX and Four Types of Speed Bump”

It is inaccurate to say that LTAD offers a “last look” for a resting order. The concept of “last look” implies that the party that submitted the resting order (1) is aware of the imminent execution of that order, and (2) has an opportunity to cancel or change the resting order in response to that information. LTAD does not allow this to happen.

The inbound, delayed order that goes into the LTAD queue is known only to the party sending that order and the Chicago Stock Exchange (CHX). CHX’s rules prohibit CHX from informing any market participant of the existence of *any* order. Therefore, the party that sent CHX the resting order will never know that a execution of the resting order is imminent. Therefore, (1) cannot happen. Because (1) cannot happen, (2) cannot happen.

This the claims made in several comment letters sent to the SEC, and in your article, are inaccurate. LTAD was designed in a manner which will never permit “last look.”

I agree that the LTAD does not allow the resting side to see any private order information, unlike last look on FX platforms. However, I’m not sure this difference has much economic effect. I’m no expert on FX compliance norms, but I think that using private order info obtained from last look is, at best, a grey area. For instance, a review of FX practices by UK regulators says:

“[I]n its current form, [last look] can potentially be abused by market makers, either by asymmetrically accepting or rejecting orders based on market moves after the order is placed, or by using the order to inform other trading activity prior to acceptance.” (p59 of pdf http://www.bankofengland.co.uk/markets/Documents/femrjun15.pdf )

If “pre-hedging” is considered an abuse by regulators, then any other use of private order information by a market maker might be considered worse.

It’s also interesting that some regulators may consider asymmetrical use of last look to be an abuse. The LTAD is arguably intended to be used asymmetrically. Some FX venues forbid asymmetrical last look, and conduct checks to ensure market makers comply with that requirement (e.g. FastMatch, p6 of pdf http://www.fastmatch.com/docs/OP1FEB2016.pdf ). I don’t know if it would even make sense to modify the LTAD so that it could only be used symmetrically. But if it’s approved, it would be nice if statistics were published on the trades that it prevents. That applies to the IEX speed bump as well.

In any case, I did not mean to suggest that the LTAD (or the IEX speed bump) are identical in every respect to last look, as practised in FX markets. There are differences — including the existence of order protection. But in my opinion, the economic implications are similar.

CHX’s filing provided data. During the there month measurement period, LTAD would have adversely affected only 20 orders not sent as part of a latency arbitrage strategy. That is 1 order every three days.

LTAD was designed to target latency arbitrage while not having much effect on others. This is very similar to radiation treatment for cancer, IMO. Highly effective and low unintended consequences.

There may be a big difference in the estimated, pre-approval number of missed executions due to the LTAD and the actual number post-approval. The LTAD may encourage the posting of orders that aren’t economically viable today, and these orders will attract marketable flow that isn’t able to actually trade with them.

CHX might believe that all of this flow is “latency arbitrage,” but I don’t see how the exchange can determine that — or precisely define what “latency arbitrage” even is. Smart order routers and stat arb strategies may be indistinguishable from “latency arbitrage.” For example, perhaps a trader previously would sweep the E-mini BBO, and SPY market-makers would cancel in response. That trader may have changed their behavior to simultaneously sweep SPY, giving them larger effective fills. The new behavior may look a lot like “latency arbitrage.”

The backward-looking statistics published by CHX also put the claimed problem in perspective. CHX believes that some 412 SPY executions would have been prevented by the LTAD in an entire *quarter*. (p107 of pdf http://www.chx.com/_posts/rule-filings/ProposedFilings/CHX-2016-16.pdf ) To make such a radical change in market structure, for less than 10 orders per day, does not make sense to me. Then again, a similar argument could have been made with respect to IEX, and they were approved — So I can understand CHX’s argument about fair treatment.

I also don’t agree with your cancer analogy. Such a small number of “problematic” orders shouldn’t be described in such exaggerated terms. And we don’t know what the consequences of the “treatment” would be. If a high-volume exchange in NJ copies the LTAD, the whole system will probably get gummed up. There is good reason to require protected quotes to be firm.